This is where the rubber meets the road on the path to getting funded. You've put in the work to prepare your startup to be fundable, you've gained intelligence on the process and who you want to invest, you've polished and flexed your pitch, and you've gained some investor interest. Now it's time to nail down the terms.
Term sheets can be really scary for new startup founders. More than anything, it's the fear of the unknown, or of making a mistake that founders may regret later, as the business grows. Term sheets are important, and can be complex, but they don't necessarily have to be. The key is knowing what to expect, knowing what you want out of a term sheet, knowing what you won't bend to, and of course having good representation to review all of the fine print.
So what is in a term sheet? What don't you want to see in your term sheets? What strategies may help founders get more of what they want?
The term sheet is the document that lays out the terms of the investment and collateral. It details what you as the startup are giving, and what you are getting in return. Then it lays out the guidelines of how both parties will act to protect the investment.
Term sheets can vary depending on what type of funding round you are in, and how much is at stake, as well as who is involved. Generally term sheets for seed rounds are going to be much lighter and shorter than for series A or beyond. The less at stake, the less complex it should be, as no one wants to unnecessarily splurge on extra legal fees, or burning time. The process can be significantly simplified when using a third-party funding portal.
In a seed round, the investor will typically be the one providing the term sheet. This may change, especially when there are multiple investors in later and larger rounds.
What's in a term sheet? Common items in a term sheet include:
A term sheet might just be one page or it could be 10 pages long. Generally speaking, simplicity is often preferred by founders, but it pays to have clarity and make sure all bases are covered. An example of a term sheet is shown in the following box, but you will need to have great counsel guiding you through the process and providing the right materials. This sample is only for your information.
Now that we've reviewed what an actual term sheet looks like, let's look at some of the most important provisions and items in term sheets and how they differ.
Some startups will raise simple debt financing. This paperwork can essentially be standard, as with any other business, real estate, or consumer loan. More common in this space are convertible notes. This is a debt instrument that also gives the investor stock options. The flexibility of convertible notes offers security from the downside, and more potential upside if the startup performs as expected. Theoretically it can also be easier for some to justify making the loan, which has specific returns and maturity dates, versus the unknown.
Convertible notes are much faster than equity rounds. There are only two documents in place, which are the convertible note purchase agreement outlining the terms of the investment, and the promissory note explaining the conversion and the amount that the investor is investing.
With convertible notes, there are only three main ingredients that the entrepreneur needs to ensure are present.
The first ingredient is the interest that the entrepreneur is giving to the investor. This is interest to be accrued on a yearly basis on the investment amount that the investor puts into the company. The interest will continue to be applied until the company does another equity round, when the debt will convert into equity with the amount plus the interest received.
The second ingredient is the discount on the valuation. This means that if your next qualified round is at X amount of premoney valuation, the investor will be converting his or her debt at a discount from the valuation that has been established in the next round by the lead investor.
The third ingredient to watch is the valuation cap. This means that regardless of the amount that is established on the valuation in the next round, the investor will never convert north of whatever valuation cap is agreed. This is a safety measure in the event that the valuation goes through the roof. It is a good way to protect your early investors and to reward them for taking the risk of investing in you at a very early stage.
Convertible notes are, in my mind, the fastest and cheapest way to fundraise. While equity rounds can be north of $20,000, convertible notes should not cost you more than $7,000.
One thing to keep a very close eye on is the maturity date. This is the date by which you agree to repay unless you have not done a qualified round of financing in which the convertible notes are converted into equity. For this reason, make sure that the maturity date is a date that you feel confident about. You need to be convinced that you will be able to raise a qualified round of financing on or before that date in order to convert the notes into equity and avoid being in default. The last thing you want to happen is to be in default and to have to shut down your business because investors are demanding their money back.
A newer instrument that has been adopted by the likes of Y Combinator is the SAFE note. The Simple Agreement for Future Equity (SAFE) aims to increase simplicity while preserving flexibility.
Y Combinator argues that these notes do not accrue interest, or have maturity dates, which makes them friendlier to entrepreneurs. That relieves a degree of extra burden that can be counterproductive to both parties.
A SAFE note automatically converts to preferred stock at the next equity round of funding, or when there is an IPO.
Some investors obviously feel much more comfortable making their funding available in multiple payments, as opposed to handing over a $1 million check to a couple of fresh-faced cofounders with a slick pitch for a tech idea. But payment in increments can hurt cash flow, potentially making it more difficult to get through to the next milestone and round.
I have a problem with investment tranches, in particular. This is because if an investor promises to give, for example, $100,000 over the course of the next six months, and on the third month decides to pull the plug because the business is not performing well enough, there is nothing you can do. Bringing a lawsuit would slow progress and cost money (ultimately, throwing good money after bad).
Entrepreneurs can expect significant investors to request seats on the board of directors. The founders and investors may have ownership, but the board of directors really has control.
If you were putting a sizable amount of money into a young company, you'd like to have a say in major decisions, too. However, it's critical for entrepreneurs to think about the big picture. You can't give away too many board seats. You don't want board meetings to become a nightmare. You want to be sure the board you have isn't a turnoff to future investors. So fill the seats on your board with care.
You can also invite people to serve as board observers. This means they can attend board meetings but won't have a vote in various matters. This can become complicated, as the investor might be particularly outspoken and may influence board members who do have a vote.
For investors, dilution can be both a necessary part of business growth and a source of fear. Full ratchet and weighted are two common terms you'll find in this provision of the term sheet. Be cautious here, and understand how antidilution clauses may impact your own profitability and the potential for raising additional funding later.
For the most part, antidilution provisions are not reasonable to have at an early stage. In the event the company goes through different rounds of financing, it is then more common to have this provision for the founder so that he or she is still motivated to stay, in the event that the founder's equity decreases substantially.
Consent to sell, first right of refusal, and cosale limitations can all be part of a term sheet. While there are some open source term sheets available, each one can be different. This makes it particularly important that founders read and reread each term sheet in its entirety, and have their legal counsel review it.
Sample term sheets can be found online at www.seriesseed.com, www.techstars.com/docs, and via the National Venture Capital Association. Each of these resources offer forms that are evenly balanced for both entrepreneur and investor.
Feel free to compare the different samples with the example provided in this chapter. I strongly suggest you look at the documents with legal counsel by your side.
What smart strategies should founders have when going into the term sheet stage? What investor tactics should they beware of?
When a founder is so close to ending the round and getting the precious funding that everyone has worked so hard for, it can cause some actors to rush and overlook critical terms and indicators that can potentially set the company up for disaster.
Several times in this book, we've highlighted the need to watch out for predatory investors. This is definitely one of those times. Bad terms may be thrown in simply because investors don't know better. In other cases, this may be due to ulterior motives. Specifically look out for:
Investors may aim to exhaust a founder who's eager to wrap things up. If you see this is happening to you, hang in and be patient. Every single provision included in documents may not make sense today, but one of them may be triggered in the long run and put you, your cofounders, and other employees in a bad space.
A piece of advice: Be unattached to the outcome. You should be prepared to walk away if you see that the investor is overtly using tactics to wear you down during the process. This could show up in the form of negotiating a clause again, or introducing something new at the last minute.
Just as founders don't want difficult or greedy investors on board, investors don't want hassle or founders who only want to take the money and run. The term sheet should facilitate a win-win for both sides.
Negotiating and getting the best deal is smart, and good business, too. If you don't show any business sense, then how is an investor going to trust that you will be able to run a profitable organization and protect his investment? Investors deserve and expect respect. While every investor is keen on honing in and finding that big win, there are plenty of startups looking for funding. So keep in mind, no matter how weary you may be, that being too difficult and making the terms unattractive won't help you achieve your goals.
Think about what is most important in advance. What do you want the outcome to be? Do you really want this investor on board, or are you just happy raising money from anyone, provided it is on your terms? How much does timing and speed matter? What happens if this deal falls through? What balance between upside potential, downside protection, and ease of dealing with you will optimize the transaction, and help you to ensure that you get what you want most?
For example, should you go in with a mindset that you'll give up a good amount of equity in order to land this investor? Should you pull out some of the quirky terms and cheesy tactics like short expiration dates to present yourself better? Put yourself in the investor's shoes, and ask what will get him to expedite.
The rule of thumb is that you will be receiving a dilution of around 20 percent per round of financing. You do not want to go over that amount. The life of a startup is long. Even if you are at a seed stage and you feel it is okay to give up a good amount of equity, you need to know that equity will not come back to you.
I would also recommend avoiding greed. As Mark Cuban has said, “It is much better to have 1 percent of $1 billion than 100 percent of nothing.”
A term sheet itself (without signatures) is not an executed deal, or even a promise. There is still due diligence to be done. So both sides can walk away and it doesn't necessarily impact the reputation of either side.
They made an offer, you made yours, and you couldn't meet in the middle. But don't talk badly about the investor just because you didn't like the terms. The next prospective investor in line might question what you'll say about her if she sends you a term sheet. So be mindful. And once you do shake hands on a deal, remember that your word and reputation is really the most valuable thing you've got. It's the only thing you've got.
Some investors will reinvest in future ventures with the same founders—even if they lost money the first time—if they trust them and like them.
But if you don't honor your word, no one is going to bet on you.
One investing nightmare that tends to recur is when founders receive a term sheet and think the deal is done. They start increasing expenses, thinking the money will be transferred. I've personally witnessed instances where a founder with a term sheet ended up not closing the deal, and the founder had to shut down because it was assumed that the money was already in place. Do not be one of these cases.